The importance of manager selection is back.
Recent years in venture capital were an anomaly defined by capital abundance. As large and novel capital sources entered the venture market due to a prolonged low-interest rate environment, venture capital deployment accelerated as companies raised larger financings, at higher valuations, more easily than ever before. Capital was relatively cheap. This environment enabled a rising tide that lifted all boats. As a result, portfolio loss rates reached historic lows, and while the best managers still outperformed, most investors benefited regardless of sector, stage or portfolio quality. But times have changed. We have entered a period where the gap between the best and the rest of managers will widen again. Only a subset of venture-backed companies (the “outliers”) will be successful in today’s more discerning market, and outperformance will depend on working with the managers that invest in those outliers and have experienced cycles.
The concept of outliers driving industry returns is nothing new – in fact, decades of historical data suggest venture returns exhibit a power law. Power law is a principle where one single investment yields returns larger than all other investments combined, often by orders of magnitude. To illustrate this principle, we went back to our database from 35 years of investing in venture capital.
Key insights were:
- The top 15 companies, on average, generated 38% of total value in that vintage investing period.
- These 15 companies represent less than 1-2% of the investment cost of the total underlying portfolio companies.
- While recent periods have lower loss rates, more than 40% of portfolio companies in older vintages returned less than cost, and up to 20% of these companies were fully written off (returning zero).
Looking at history, the prospect of more companies either shutting down or generating middling outcomes is the norm. In today’s market, the 3rd, 4th or 5th best company in a given sector category, with weak product-market fit or less attractive business models, should once again struggle to raise capital. This is healthy. At the same time, the best companies will continue to accelerate and grow with stronger economics given less competition for resources and talent.
In turn, we think the outliers will continue to succeed and drive overall industry returns, but how do you gain exposure to them? The key is manager selection. Experienced managers that have a strong, and many times long, track record of sourcing and building outliers stand to benefit in this market. While any manager, emerging or established, can produce top-quartile returns in any given vintage, only a handful of managers have shown the ability to do it consistently through different economic cycles. Those experienced managers are well-positioned to gain access to these outliers and continue to generate strong returns.
Venture has always been about hitting home runs, but not every manager can be a slugger. The power law of returns remains. That dynamic was obfuscated in a market where most companies could raise capital easily. The current cycle is likely a reversion back to the future (or the historical norm). Venture capital is an attractive asset class when you gain exposure to outliers – our objective, then, is to select high-quality managers that have proven the ability to find the right companies and shape them into future outliers.